Some Perspective on Federal Funds Rate Hikes

Frank Yozwiak

In the last week of September, the Federal Reserve raised its federal funds target range for the third time in 2018. The target range was increased by a quarter point to 2.00% – 2.25%, the highest since April 2008. Raising the rate is an indication of the Fed’s confidence in a strong economy. The Fed sets and adjusts this rate in an attempt to both maximize employment and maintain inflation at a target of 2%. Currently, the unemployment rate is approximately 3.9% (an 18-year low) and inflation is at 2.8%.

The Fed will raise or lower the federal funds rate for a variety of economic reasons. In very general terms, raising the rate can help stave inflation by making borrowing money more expensive, thereby decreasing the available money supply; whereas by lowering the rate, borrowing money is cheaper, which can lead to increased spending.

So, what does it mean for you? An increase in the federal funds rate can create a ripple effect which, depending on your perspective, can be seen as good or bad.

A higher federal funds rate leads to an increased prime rate. This is the rate that banks extend to the most credit-worthy borrowers. Higher lending rates give banks incentive to lend more money because they stand to make more money over the term of the loan. On the flip-side is the borrower’s perspective: an increase in the federal funds rate means borrowing money becomes more expensive. New fixed rates will increase, as will existing variable rates. Carrying costs of short-term debts, such as credit card debt, home equity lines of credit, and other adjustable-rate loans are likely to increase as a result.

Responsible lending and borrowing can lead to overall economic growth through (among other things) more building and development projects, and more business capital spending and expansion. However, irresponsible lending and borrowing can have serious detrimental effects (See: 2007-08).

For those looking to save, the rate increase means more favorable money-market and CD rates. The same is true for retirees and anyone else living on a fixed income – an increase in savings and CD rates can mean an increase in interest income. While the increase is not massive, any increase in potential returns is always welcome.

For example, a high interest rate on savings accounts in 2015 was around 1.1%. Today, some high interest rates on savings accounts are in the neighborhood of 2.25%. Again, the increase is not enormous, but that amounts to an additional $115 in annual interest on a $10,000 savings account. CD rates are even better: some 5-year CDs are currently paying rates around 3.4%, up from 0.86% in early 2016.

From another perspective, those with credit card and other short-term debt are likely less than thrilled about the increase in the federal funds rate. Credit card interest rates already average a record high 17.32%. Excluding the most recent rate hike, the federal funds rate increases since late 2015 have cost those with credit card debt a collective $9.65 billion in interest charges. The September 2018 rate hike will likely increase the interest charges paid by another $1.6 billion.

Mortgage rates are also affected by the increase. An average 30-year fixed-rate mortgage is now around 4.7%, compared to 4.09% in 2015. Holding all else equal, a person buying a $300,000 home with 20% down today will pay roughly $31,120 more over the term of the mortgage than if they bought the same home with the 2015 mortgage rates.

Homeowners with existing fixed-rate mortgages will be unaffected, but those with adjustable-rate mortgages (ARMs) or home equity lines of credit (HELOCs) will likely feel the change, perhaps sooner than they might think. While some ARMs will adjust their interest rate annually, HELOCs could adjust within 60-days.

New auto loans will also change with the rate hikes. The difference, however, will not be as impactful on your bank account simply because the price of a new car (most new cars) is significantly less than a house. For example, the increase in the federal funds rate means that a person buying a $25,000 car on a 5-year loan will pay roughly $3 per month more in interest.

Businesses will likewise feel the change of the increase in rates. Holding everything else equal, for a business with variable-rate debt, or one that is constantly acquiring new debt, an increase in the federal funds rate means that the company will see a higher debt expense, which potentially means lower relative profits.

While the rate hikes do increase the costs of borrowing for both consumers and corporations, it generally takes 6-18 months to see the effects of a rate increase in the economy. The next several months will be very indicative of how both consumers and businesses alike are able to absorb increased debt carrying costs. For those looking to save in CDs or money-market accounts, there has not been a better time in the past several years.